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Financial Crises as the Failure of Arbitrage: Implications for Monetary Policy
Makoto Saito and Shigenori Shiratsuka
This paper attempts to view financial crises as the failure of arbitrage among financial markets, and takes the gJapan premiumh phenomenon observed in offshore money markets as an important example in favor of this view. In addition, we reconsider, from this perspective, the open market operations conducted by a central bank during a period of financial distress. The paper first derives from the existing theoretical literature several implications regarding how arbitrage among markets is prevented when financial institutions such as investors and intermediaries suffer from severe liquidity constraints, and then examines empirically such theoretical implications using the data available from offshore money markets. Given these implications, explored both theoretically and empirically, the paper finally discusses a possible role played by a central bank in recovering market liquidity when markets are segmented in the absence of financial arbitrage.
Key words: Financial market instability; Japan premium; Allocation of liquidity; Failure of arbitrage; Money market operation
Views expressed in Monetary and Economic Studies are those
of the authors and do not necessarily reflect those of the Bank
of Japan or Institute for Monetary and Economic Studies.
Copyright
 2001 Institute for Monetary and Economic Studies, Bank of Japan
All Right Reserved.
 
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